The hazards of index funds

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sophie
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The hazards of index funds

Post by sophie » Wed Jun 27, 2018 7:16 am

Very interesting article on the effect of passive indexing on the markets! I had been wondering about some of this myself which is why I decided to start collecting individual stocks for the "deep" 1/3 of my stock allocation.

On the other hand, there's nothing here to say that overall performance of indexes will suffer over time, just that it might be a lot bumpier ride than you might otherwise expect: outperformance when the overall market is doing well, and underperformance when it's not.
The most well-known indexes are weighted based on the size -- i.e., the market capitalization -- of the companies within. That includes the most commonly tracked index, the S&P 500, which is essentially a collection of the 500 largest publicly traded U.S. companies as measured by market cap (some exceptions apply). The largest companies, then, receive the most investment when money flows into passive investments.

That money acts like water on the pumpkin patch. Every time money flows from active to passive management, it's as though water is flowing to the biggest pumpkins (i.e., holdings) by virtue of their size. And then, as a consequence of the new money, the big get bigger.

If this sounds peculiar, or even illogical, that's because it is. But it's how passive indexing works...
https://www.fool.com/investing/2018/06/ ... ubble.aspx
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Xan
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Re: The hazards of index funds

Post by Xan » Wed Jun 27, 2018 8:49 am

I've taken to doing Total Stock Market funds. I've also been wondering about weightings other than market cap, but funds like that seem to have much higher expenses.
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ochotona
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Re: The hazards of index funds

Post by ochotona » Wed Jun 27, 2018 10:03 am

I have been looking at Research Affiliates Fundamental Index (RAFI) weighted funds, which are at Schwab as house brand ETFs using the "FN" as the first two letters of the symbol... but they don't seem to outperform. Maybe something to try in the next stock market cycle. Another one to monitor is RSP, the equal-weight S&P500 ETF.

I think right now everyone is just piling into the Big Names in the stock market, of course much of which is due to cap-weighted indexing itself, but this may end in tears someday. In the aftermath, the fundamental factors tracked by the RAFI ETFs may be more effective. They should be more effective, but for now they are being drowned out by stupid.
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Desert
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Re: The hazards of index funds

Post by Desert » Wed Jun 27, 2018 12:20 pm

I've thought about this quite a bit too. Fundamentally, cap-weighted index funds tend to be growth funds, since the hot, large companies make up a larger and larger portion of the index as investors flock into them. I've also studied RAFI and equal weight funds, as ochotona mentioned. Those funds' behavior can pretty accurately be explained based on being more small cap and more "valuey" than something like TSM. So one could tilt towards small and value and pick up those factors at a lower cost.

In studying Wellesley, that fund's equity portfolio is not cap-weighted, but is rather a relatively small number of stocks, mostly large cap value. In backtesting equity allocations to compare with Wellesley, a 3 x 1/3 split between SCV, MCV and LCV came pretty close. If one really buys into the persistence of small and value factors, that could be a way to go all-in on that belief, while completely avoiding large growth.
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ochotona
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Re: The hazards of index funds

Post by ochotona » Wed Jun 27, 2018 1:42 pm

Value has done poorly in recent years, meaning it could do well in the future.
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Re: The hazards of index funds

Post by Dieter » Wed Jun 27, 2018 4:04 pm

Xan wrote:
Wed Jun 27, 2018 8:49 am
I've taken to doing Total Stock Market funds. I've also been wondering about weightings other than market cap, but funds like that seem to have much higher expenses.
One thing to like about GB with it's SCV tilt.

Of course, SCG has done better recently. Could just add Small or mid index in place of SCV -- any diversifies away from huge growth stocks......
Last edited by Dieter on Wed Jun 27, 2018 11:08 pm, edited 1 time in total.
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Desert
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Re: The hazards of index funds

Post by Desert » Wed Jun 27, 2018 5:01 pm

ochotona wrote:
Wed Jun 27, 2018 1:42 pm
Value has done poorly in recent years, meaning it could do well in the future.
I agree. Growth has been leading for years.
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Re: The hazards of index funds

Post by boglerdude » Thu Jun 28, 2018 1:05 am

https://www.bogleheads.org/forum/viewtopic.php?t=252434

A problem with "everyone indexing" might be panic. I dont know what companies I own. Stock pickers who research fundamentals might be less likely to panic sell compared to Joe six-pack. Or, maybe not...traders gotta trade.
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ochotona
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Re: The hazards of index funds

Post by ochotona » Sat Sep 01, 2018 7:39 am

I am moving my 401(k) to the actively managed PRIMECAP Odyssey Aggressive Growth fund. I noticed it has outperformed the S&P500 but the drawdown in last recession was less than the S&P500. Nice combo! Someone was steering it.
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Re: The hazards of index funds

Post by pugchief » Sat Sep 01, 2018 8:49 am

ochotona wrote:
Sat Sep 01, 2018 7:39 am
I am moving my 401(k) to the actively managed PRIMECAP Odyssey Aggressive Growth fund. I noticed it has outperformed the S&P500 but the drawdown in last recession was less than the S&P500. Nice combo! Someone was steering it.

"past performance is no guarantee of future results"

Among other things, I was holding Fairholme and T Rowe Price Capital Appreciation during the 2008 meltdown, specifically because they both held up so well during the 2000 bear market. Guess what happened: the both turned in poor performances in 2008. And that is how I came to the PP.
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ochotona
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Re: The hazards of index funds

Post by ochotona » Sat Sep 01, 2018 9:20 am

Yup. PPNGOFP! I just want to di-worse-ify my equities away from SP500
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Re: The hazards of index funds

Post by Tyler » Sat Sep 01, 2018 10:32 am

If you're interested in factors and looking to diversify away from the capitalization-based market as a whole, I'd recommend reading this book by Larry Swedroe. It will help you understand each of the major factors, how they work, and just how dependable they are so you're not swinging in the dark at whatever sounds compelling at the time.
PortfolioCharts.com : a picture is worth a thousand calculations
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